Contents: 6 sections
Cambridge IGCSE Accounting 0452 · Core and Extended
Syllabus points
- Explain the disadvantages of not keeping a full set of accounting records.
- Prepare opening and closing statements of affairs.
- Calculate profit or loss from the change in capital.
- Calculate sales, purchases, expenses and missing figures from the information available.
- Apply mark-up and margin to find missing figures.
The problem
Many small businesses keep receipts, a bank statement and little else. There is no ledger, so there is no trial balance and no ready-made income statement. The accountant has to reconstruct the missing figures from what does exist.
The disadvantages of keeping records this way are worth knowing: errors and fraud are hard to detect, profit cannot be measured accurately, the owner cannot see which parts of the business are working, a bank is less likely to lend, and the tax authorities may not accept the figures.
Profit from the change in capital
Where almost nothing was recorded, profit can still be found from the accounting equation.
profit = closing capital − opening capital + drawings − capital introduced
The logic is that capital moves for only three reasons: it rises with profit and with capital introduced, and it falls with drawings. Take away the last two and what is left is profit.
Each capital figure comes from a statement of affairs: a list of the assets and liabilities at that date, with capital as the difference. It is not a statement of financial position, because it is put together from estimates and physical checks rather than from ledger balances.
At 1 January the business had premises $60 000, inventory $7 000, receivables $3 200, bank $4 800 and payables $5 000. At 31 December: premises $60 000, inventory $8 100, receivables $4 400, bank $6 500 and payables $4 200. Drawings for the year were $14 000 and the owner paid in $3 000.
Opening capital is 60 000 plus 7 000 plus 3 200 plus 4 800, less 5 000, which is $70 000.
Closing capital is 60 000 plus 8 100 plus 4 400 plus 6 500, less 4 200, which is $74 800.
Profit is 74 800 minus 70 000, which is 4 800, plus drawings of 14 000, less capital introduced of 3 000, giving $15 800.
Reconstructing the missing figures
Where more information exists, a full income statement can be built. The method is the same every time: draw a T-account, put in everything you know, and the missing number is the balancing figure.
Credit sales come from the sales ledger control account, with receivables at the start and the end, plus receipts, discounts, returns and write-offs.
Credit purchases come from the purchases ledger control account in the same way.
Cash sales, drawings or a theft come from a reconstructed cash account, where the balancing figure is whatever is missing.
An expense for the year comes from the expense account: cash paid, adjusted for opening and closing accruals and prepayments.
Trying to do these by formula invites sign errors. The T-account does the thinking for you.
Trade receivables were $3 200 at the start and $4 400 at the end. Cash received from customers was $46 000, discount allowed $700 and sales returns $500.
Credit sales are the balancing figure: 4 400 plus 46 000 plus 700 plus 500, less 3 200, which is $48 400.
Mark-up and margin
Both express gross profit as a percentage, and they differ in what they are a percentage of.
- Mark-up is gross profit as a percentage of cost of sales.
- Margin is gross profit as a percentage of revenue.
With cost of sales $40 000 and gross profit $10 000, revenue is $50 000. The mark-up is 10 000 over 40 000, which is 25%. The margin is 10 000 over 50 000, which is 20%.
Converting between them is quicker than starting again. A mark-up of 25% is a margin of 25/125, which is 20%. A margin of 20% is a mark-up of 20/80, which is 25%.
The usual use is to find a missing figure. Revenue is $90 000 and the margin is 40%, so gross profit is $36 000 and cost of sales is $54 000. With opening inventory and purchases known, closing inventory is then the balancing figure, which is how the value of inventory lost in a fire or a theft is calculated.
Reading the question to see which of the two it gives is the first thing to do. Using mark-up where margin was meant produces a plausible answer that is entirely wrong.
Common mistakes
- Using mark-up where the question gives margin, or the reverse.
- Forgetting to add back drawings when calculating profit from the change in capital.
- Adding capital introduced instead of deducting it in that same calculation.
- Calling a statement of affairs a statement of financial position.
- Treating cash received from customers as the sales figure.
- Forgetting the opening balances when reconstructing an account.
- Giving only the final answer, when each step of the reconstruction carries its own mark.